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Why We Sold a Terrific Stock

We thought we'd own this stock for a long time.

Our Inside Value newsletter is dedicated to identifying undervalued stocks. Our favorite strategy is to find a strong company with great growth prospects, trading at an excellent price. You can often hold such stocks for years, riding their long-term growth to extraordinary returns.

We recommended OSI Restaurant Partners (NYSE:OSI) back in the October 2006 issue -- and thought investors could hold it for a long time. Yet we recently issued a "sell" recommendation. The story is noteworthy not just for the short holding period, but because it illustrates one significant downside of value investing.

The businessOSI operates several casual dining restaurant chains. Its biggest brand is the Outback Steakhouse chain, bringing in almost 70% of the company's revenue, but it also owns Italian and seafood chains. The company has grown steadily for the past decade -- its revenues have increased at a compound annual rate of 15%.

Now, the restaurant industry is highly competitive. Just in the steakhouse category, you have Ruth's Chris Steak House (NASDAQ:RUTH), RARE Hospitality's (NASDAQ:RARE) LongHorn, and Texas Roadhouse (NASDAQ:TXRH). And when you consider the overall casual dining niche, you get even larger competitors like Darden Restaurants (NYSE:DRI), Brinker International (NYSE:EAT), and Applebee's (NASDAQ:APPB).

So it's not an easy market, but it's a market in which OSI has excelled. The company has established a successful brand through a combination of attractive venues, high-quality service, and reasonable prices. The founders are still involved as chairman and vice chairman. These guys know how to build a business, and OSI's secondary brands have room to grow. So, relative to others in the restaurant industry, OSI is well positioned competitively.

ValuationOf course, valuation is critically important when picking stocks, and it was OSI's price that made it particularly interesting when we first analyzed it last year. At the time, the company was consolidating after its decade of growth. Investors were concerned about Outback's same-store-sales growth and whether the brand itself was weakening. That had pushed share prices to near five-year lows.

The company, however, was taking steps to address the concerns, focusing on revitalizing the brand. What's more, since historically most of the capital expenditures went toward expansion, the financials understated the true cash-generating potential of the business. Though the stock was trading at $33, we thought it was worth about $43, with the potential to be worth a lot more if the company executed well over the long term.

Why we parted waysSo, if this was a long-term play, why did we issue a sell recommendation only eight months after the recommendation? Well, Bain Capital made an offer to acquire the company for $40 (it was later sweetened to $41.15). It wasn't a great offer, coming in below our estimates of intrinsic value. But the upside from that level seemed small, and if the deal fell through, the shares would likely fall temporarily. Plus, we had other newsletter recommendations trading way below fair value that had the potential for huge returns. It didn't make sense to continue holding OSI when there are so many stocks offering bigger upsides.

Our experience with OSI also shows one of the downsides of value investing. We were hoping for excellent long-term returns from the stock. The acquisition gave us a quick 20% return. This is an acceptable return, but it also meant that we did not benefit from the long-term growth of the company.

The Foolish bottom lineThis can be a downside of value investing. Often, when you find a value stock, other investors recognize the value, too, and may decide to buy the company. For example, four of our Inside Value recommendations have been acquired, all less than a year after they were recommended, for an average return of 37%.

While this can result in excellent short-term returns, such investments never achieve their full long-term potential. If you're interested in seeing our top picks, you can read about them with a free trial.

Fool contributor Richard Gibbons fears the vengeance of the cows when they hear about the OSI recommendation. He does not have a position in any of the stocks discussed in this article. The Motley Fool has a disclosure policy.